UK equities are likely to perform in line with global indices says, Dean Turner, investment strategist at HSBC Private Bank.

In a note issued this week, Turner writes that the improvement in the economic outlook has been much better than expected but that the recovery will only entrench if there is an improvement in household earnings, which are still falling in real terms.

“Although unemployment is still high in the UK, exerting downward pressure on real wages, some lead indicators, such as the rising number of job vacancies point to a more positive outlook, in our view”.

Turner says that in the Bank’s view, a combination of stronger growth and loose monetary policy is likely to influence the performance of UK investments over the medium-term.

The note then lays out its thoughts on bonds, equities and sterling.

1) Bonds

We have had a negative rating on gilts for some time, wanting to limit our exposure to the threat of rising yields. Bond yields have indeed risen in recent months, however, we do not believe that this trend will reverse, thus it does not present an opportunity to enter the market.
Although the Bank of England has tried to limit the rise in long dated yields through its new policy of forward guidance, so far this has not proved successful. Over the medium-term, we expect that yields will rise further as the economy strengthens and the rate of unemployment falls towards the 7% level. Moreover, if, as we expect, the BoE keeps policy accommodative longer than is needed, this may cause inflation expectations to rise, which would put bond prices under further pressure, in our view.

It is important to remember that government bonds should still be held for their diversification benefits within a portfolio, however, in our view, what gilts are held should have a short duration, say, 3-5 years in length, in order to limit downside risks. Furthermore, we see slightly more value in the sterling corporate bond market, although, again, we prefer to keep the duration short.

2) Equities

UK equities have performed well so far this year, with the FTSE 100 index gaining just under 10%. We currently have a neutral rating on UK equities, expecting returns to be broadly similar to the MSCI World index. Although the economic backdrop in the UK has shown a noticeable improvement, this is unlikely to have a significant impact on the outlook for corporate earnings, in our view. The FTSE 100 is dominated by large multinationals which means that over 2/3 of revenues come from overseas markets. To be sure, the UK is not alone in seeing better economic data, Europe and US are also surprising to the upside, thus we would expect that earnings can continue to grow, but this will less likely be influenced by developments in the UK. Another factor to consider for the UK is the high exposure of the Energy and Materials sectors, which account for approximately one third of all FTSE 100 profits. The slowdown in demand for commodities has already hurt earnings for these sectors, although the outlook should improve over coming quarters, but, in our view, this is priced into expectations.

On a more positive note, the valuation of UK equities when compared to gilts still looks compelling in our view, thus we prefer stocks relative to bonds in the UK, but judge that the UK market will only deliver returns similar to the MSCI World index.

3) Sterling

Sterling has benefited from the run of better-than- expected economic data, gaining around 5% against the US dollar over the past month. This has occurred in spite of the BoE’s commitment to loose monetary policy. In our view, this strength relative to the dollar is unlikely to persist over the medium term, as stronger US economic growth, a swifter end to quantitative easing, and higher interest rates are likely to favour the American currency.

Sterling has been pretty much range bound relative to the euro for most of this year, and we do not see this ending in the near term. As mentioned above, the UK is not alone in enjoying a healthier economic outlook; a recovery also seems to be underway in the Euro-area, furthermore, it seems reasonable to assume that interest rate policy in both the UK and Euro area remains loose.

In summary, it is welcoming to see the UK economy participating in what looks to be a synchronised upswing in activity in the developed markets. Moreover, this is happening at a time when the BoE is guiding market expectations in the direction of low interest rates until such time that unemployment shows a meaningful decline. In our view, this is likely to favour UK stocks over bonds, and is likely to see sterling loose the ground made up against the dollar over the last month.